Many Concerns About Third Avenue

We have downgraded our assessment of Third Avenue Management, the advisor to the Third Avenue family of mutual funds, lowering the firm's Parent rating to Negative from Neutral. (The Parent rating is one of five pillar ratings that Morningstar analysts assign in making an overall assessment of a fund.)

We lowered Third Avenue's Parent rating in the wake of Third Avenue Focused Credit's sudden demise, which we believe reflects a profound management and governance failure. But our concerns about the firm's stewardship practices preceded this event, as we'd previously expressed concern about turnover among Third Avenue's investment staff, persistently weak performance, and redemptions.

What Happened: In Review Third Avenue Focused Credit was a debacle. Redemptions at the fund spurred a crisis as management found it difficult to get a reasonable price for its distressed debt. After trying to move the fund into a liquidating trust, Third Avenue was told by the SEC to keep it running as an open-end mutual fund, albeit one that shareholders can't buy or sell. The fund will gradually sell holdings with the goal of liquidating but the unusual structure enables them to sell at a slower pace.

Nonetheless, the shutdown of Focused Credit shone a light on myriad issues at this fund and Third Avenue Management. Some of these, like a harsh high-yield market and shareholder redemptions, are outside of Third Avenue's control. But the firm is hardly the victim here.

What Failed Perhaps the most fundamental failure came at the outset in the firm's decision to offer the Focused Credit strategy as an open-end mutual fund at all. The open-end format demands daily liquidity, yet this was no ordinary high-yield bond fund. Among other items, the fund invested in high-yield bonds, loans, common stocks, and even some private equities, many of which became increasingly illiquid. Its weighting in nonrated debt was the highest in the peer group, and its weighting in B rated or lower debt was second-highest. The underlying distressed bonds central to the strategy were particularly prone to illiquidity. Management, and the board that oversaw the fund, failed to reconcile this inconsistency, and that mismatch ultimately proved to be the fund's undoing.

However, once the decision to launch the fund had been made, management and the fund's board had a responsibility to monitor the fund's liquidity and make necessary adjustments to ensure the fund could meet redemption requests in an orderly way. They failed to do so--management in miscalculating the potential illiquidity of the fund's holdings and the board in not holding management's feet to the fire as a secondary check.

And then there is the matter of suspending redemptions, an almost unheard-of step that the board had to take in order to prevent the fund from completely imploding. While we think it's deplorable that Third Avenue management and the fund's board allowed the fund to slip into so precarious a state, we also recognize that they had little choice but to suspend redemptions. Had they met further redemption requests, it likely would have decimated the fund's performance, leaving remaining shareholders with even deeper losses.

That said, the process by which Third Avenue and the fund's board sought approval for suspending redemptions raises questions. Initially, the fund was to transfer its remaining assets (less a small dividend to shareholders) to a liquidating trust, from which liquidating payments were to be made in the future. However, Third Avenue and the fund's board were forced to undo that plan--in effect, to transfer the assets from the liquidating trust back to the open-end fund--when the SEC expressed concerns. Thus, for nearly a week, the fund ceased to exist--no net asset value was struck--only to be resurrected at the SEC's behest. This is highly unusual.

What's particularly disappointing about the management of the fund is that Third Avenue was unable to avoid a situation it experienced before: Shareholder redemptions having a meaningful impact on portfolio construction. Consider that between 2008 and 2011, redemptions at

Similarly, Third Avenue Small Cap Value TASCX has suffered steady outflows since 2008. When Curtis Jensen was running the fund, Third Avenue's valuation discipline kept the fund invested in what he considered the cheapest stocks, including Parco and Sapporo Holdings. Both companies were part of the sentiment-driven Japanese small-cap market that is subject to varying degrees of liquidity. After Jensen was surprised by an outcome initiated by an activist investor with whom he disagreed, he was fortunate enough to eventually find a strategic buyer for Sapporo and didn't need to dump the stock in the market. Nonetheless, as those illiquid positions grew to be larger in size, they had a materially negative impact on results, and finding a strategic buyer for one of those holdings took time.

Third Avenue Focused Credit is another example of a risk-management failure at the firm. The fund's board, which is ultimately responsible for risk oversight, deserves some of the blame, though it's unclear how engaged the board might have been as the board isn't required to communicate its meeting minutes or provide shareholders with a summary of its actions. In the fund's most recent discussion of the annual renewal of investment advisory agreements (which is required disclosure, and the most recent is dated Oct. 31, 2014), there was no mention of special risks, though the board did acknowledge the fund was "capacity constrained."

What Lies Ahead Former CEO David Barse certainly deserves blame for launching a fund with such a challenge in meeting daily redemptions. He has left the firm. He has also resigned from the fund board, leaving Whitman as the chairman and, for now, the only interested director.

Third Avenue will not name a successor CEO. Rather, a previously existing management committee, composed of president and CIO David Resnick, CFO and COO Vincent Dugan, general counsel Jim Hall, and portfolio managers Jason Wolf and Matt Fine, will assume leadership for the company.

Barse was a staunch proponent of Third Avenue Focused Credit--he is a bankruptcy lawyer and had been instrumental in Third Avenue's history in distressed securities, serving on the board of directors of Covanta since 1996. The new leadership structure represents a departure from Third Avenue's history, and it will take some time to assess whether the firm will be successful with the new structure.

It also remains to be seen whether

To date, Barse is the only casualty, voluntary or otherwise, from the Third Avenue Focused Credit mishap (though certainly its shareholders have also been harmed). Portfolio manager Thomas Lapointe has been retained, as Third Avenue acknowledged that he and his team know the portfolio the best. Time will tell if there are other departures, but there is some heightened risk that others leave.

Investment Staff Turnover Has Been an Issue The Third Avenue Focused Credit disaster and subsequent leadership change triggered our downgrade of Third Avenue's Parent rating to Negative from Neutral on Dec. 14, 2015. However, Morningstar has outlined other concerns for some time.

Specifically, Third Avenue has undergone a significant level of investment-staff turnover. Other than Whitman, who remains part of the research team but is managing only private funds, and Michael Winer, who is the longest-tenured manager on Third Avenue's gem of a fund

Instead, the firm has lost most of its most-seasoned managers. These include Lapey, who Whitman had mentored for several years on flagship Third Avenue Value. He left two years after Whitman relinquished control and with mixed performance. Small Cap Value's Jensen, who Whitman hired in 1995 after being impressed by his chops in a Yale investment class that Whitman was teaching, left three months after Lapey in 2014. Both of these departures came shortly after Third Avenue International Value's TAVIX Amit Wadhwaney announced in March 2014 his departure later that year. As a result of management turnover and generally weak results, Morningstar downgraded all three funds' Analyst Ratings and Third Avenue's Parent rating to Neutral between September 2013 and June 2014. (Given in part the small asset bases of Small Cap Value and International Value, we no longer maintain active coverage on those funds.)

Most recently, Michael Lehmann, who had been managing institutional assets for some time and was added to Third Avenue Value in early 2013, left in mid-October 2015 after 18 years with the company. He had been touted as one of Third Avenue's distressed-debt specialists. Furthermore, several analysts have come and gone from the firm. All told, since early 2013, 15 portfolio managers and analysts have left, including six team members in 2015.

Third Avenue has hired some experienced managers with good credentials, but all told, it's a fairly new investment team. The team currently numbers 22, more than half of whom have been at the firm for less than five years. As a group, its record is short, but the team has overall produced weak performance results while having to deal with investor redemptions across the lineup. With the Focused Credit blowup creating more stress, there is clearly a risk of further upset to the firm's investment staff.

Weak Performance, Outflows Spur Concern Third Avenue has long used a disciplined value approach that can be in and out of favor for stretches of time. To a large extent, value strategies have been out of favor in this most recent bull market, and so the underperformance of Value, Small Cap Value, and International Value can be explained as a style disadvantage. But even compared with like-minded peers, the funds have not performed well. The manager disruption makes it even tougher to be patient with the funds because the teams don't have the track record to properly set expectations.

Continued outflows from the funds raise other risks. Third Avenue to date has been committed to providing ample research resources. That's commendable, but at some point, funds with small asset bases struggle with economic viability. Third Avenue International Value seems the most at risk. After losing nearly $900 million to shareholder redemptions in 2015, the fund's assets sit at roughly $150 million. It's most recent annual report shows an expense ratio of 1.45%, which is 2 basis points higher than last year's, giving it a Morningstar Fee Level of High. (This fund has long had above-average fees, with a management fee of 1.25%, which makes it statistically unlikely to outperform over the long term.) If weak performance endures, redemptions continue, and expenses continue to move higher, the chances of the fund surviving diminish.

Conclusion Although Focused Credit and the mismanagement of its shuttering spurred Third Avenue's Parent rating downgrade to Negative, Morningstar has for years expressed concern about turnover among the investment staff, persistently weak performance, and redemptions. New concerns include changes in the executive management function, as well as new regulatory worries, now that the SEC and Massachusetts Attorney General are investigating Third Avenue's handling of Focused Credit.

Third Avenue was for years a successful value shop under the tutelage of Whitman. But as he stepped back during the past decade, the firm failed to maintain that success. Third Avenue has much work to do before it can regain its status as a premier investment shop. Whether its shareholders or its owners can stay committed remains to be seen.